An employer offers a cafeteria plan to its employees so that they can buy benefits with pre-tax dollars. This plan allows employees to reduce their income tax liabilities.

One type of cafeteria plan is the flexible spending account (FSA), under which cash is withheld from employee pay and stored in an account, which employees can then draw upon to pay for certain qualified types of expenditures.

For example, an employee expects to incur $1,000 of medical expenses in the coming year, so she has this amount deducted from her pay in equal installments over the year. When she pays for these medical expenses, she forwards the receipt to the plan administrator, who reimburses her from the $1,000 fund. The $1,000 amount withheld from her pay is not subject to income taxes.

Problems with the Cafeteria Plan

Though a cafeteria plan arrangement can certainly reduce an employee's taxes, the plan can backfire if an insufficient amount of actual expenditures are applied to the withheld funds. This is a particular problem because employees are only allowed to adjust the amount to be withheld at the beginning of each year, so the withholdings cannot be adjusted for any interim changes in related expenditures (note: adjustments can be made if an employee has a change in status related to marriage, number of dependents, employment, and a few other factors). If the actual expenditures applied to the withheld funds are lower than the amount withheld, the employee loses the difference. Because of this "at risk" issue, employees customarily set aside fewer funds through an FSA than they actually expect to offset with related expenditures.

One way to avoid losing money under an FSA is to accelerate the amount of qualified expenditures into the current calendar year. For example, an employee elects to obtain an additional prescription before the end of the year, even though she has not yet run out of the last prescription. She can then charge the additional prescription cost against her FSA fund.

Another problem with FSA accounts is that separate FSA accounts deal with separate issues, and expenditures related to one account cannot be applied to the funds remaining in another account. For example, an employee has an FSA for medical expenses and another for dependent care. She has used up the entire amount in the medical expenses FSA, but still has $2,000 remaining in her dependent care FSA. If she incurs additional medical expenses during the year, she cannot apply them against the remaining funds in the dependent care FSA.

A final FSA problem applies to the company sponsoring the plan. An employee could apply an expenditure against his FSA early in a calendar year that will offset a large amount of his full-year FSA deductions, even though the deductions have not all been made from his pay. If that employee were to then leave the company, the company would have to absorb the difference between the reimbursed amount and the deducted amount.

For example, an employee has $50 deducted from his monthly paycheck for a medical FSA, which will eventually create an FSA fund of $600. In early February, he submits medical expenses for $600, for which he is paid by the fund administrator. He then leaves the company, leaving the company liable for the remaining $550 that had not yet been deducted from his pay.